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Fourth
edition

INTERNATIONAL FINANCE
Maurice D. Levi

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International Finance

Maurice D. Levi

ISBN 978-0-415-30899-1

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www.routledge.com ï an informa business

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International Finance
Fourth edition

In today’s global economy, the international business community requires a thorough knowledge and understanding
of the complexities of international finance.
In this fourth edition, Maurice D. Levi successfully integrates both the micro and macro aspects of international
finance. The author explores managerial issues and focuses on problems that arise from financial trading relations
between nations, while covering key topics such as:
“
“
“
“
“

organization of foreign exchange markets,
determination of exchange rates,
the fundamental principles of international finance,
foreign exchange risk and exposure,
fixed and flexible exchange rates.

This impressive new edition builds and improves upon the popular style and structure of the original. With new data,
improved pedagogy, and coverage of all of the main developments in international finance over the last few years,
this book will prove essential reading for economics and business students.
Maurice D. Levi has 30 years of teaching experience in the area of international finance.



International
Finance
Fourth edition

Maurice D. Levi


First published 2005
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
Simultaneously published in the USA and Canada
by Routledge
270 Madison Avenue, New York, NY 10016
Routledge is an imprint of the Taylor & Francis Group
# 2005 Maurice D. Levi
Typeset in Perpetua and Bell Gothic by Newgen Imaging Systems (P) Ltd, Chennai, India
Printed and bound in Great Britain by Bell & Bain Ltd, Glasgow
All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any
electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording,
or in any information storage or retrieval system, without permission in writing from the publishers.
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library

Library of Congress Cataloging in Publication Data
A catalog record for this book has been requested
ISBN 0–415–30899–2 (hbk)
ISBN 0–415–30900–X (pbk)


To Kate
‘‘As for foreign exchange, it is almost as romantic as young love, and quite
as resistant to formulae.’’
H.L. Mencken
(As you shall see, it is not entirely resistant to formulae!)


About the author

Since receiving his PhD from the University of Chicago, Maurice D. Levi has taught and written research
papers in a wide variety of areas of finance and economics. This broad range of research and teaching interests form the foundation for this book in international finance, a subject that he believes to be best treated
as an application of financial and economic principles, rather than as a separate and isolated subject area.
Professor Levi has published research papers on financial market anomalies, the effectiveness of
monetary and fiscal policy, the relationship between inflation and interest rates, the effect of taxes on
international capital flows, and the link between inflationary expectations and unemployment, as well as in
the numerous areas of international finance that are reflected in this book. He has also written in the areas of
econometric methods, macroeconomics, labor economics, environmental economics, money and banking,
and regional economics. His papers have appeared in just about every leading research journal in finance
and economics including: American Economic Review; Econometrica; Journal of Political Economy; Journal of
Finance; Journal of Monetary Economics; Journal of Money, Credit and Banking; Journal of International Money and
Finance; Journal of International Economics; Management Science; Ecological Economics, and Journal of Econometrics.
He is also the author of Economics and the Modern World (Heath, Lexington MA, 1994), Economics Deciphered:
A Layman’s Survival Guide (Basic Books, New York, 1981), and Thinking Economically (Basic Books,
New York, 1985) and the coauthor, with M. Kupferman, of Slowth (Wiley, New York, 1980).

Since joining the Sauder School of Business of the University of British Columbia, Professor Levi has held
visiting positions at the Hebrew University of Jerusalem, the University of California, Berkeley, MIT,
the National Bureau of Economic Research, the University of Exeter, University of New South Wales, and
the London Business School. He has received numerous academic prizes and awards including Killam and
Nomura Fellowships and the Bronfman Award.


Contents

List of illustrations
Preface
1 THE WORLD OF INTERNATIONAL FINANCE

Unique dimensions of international finance
The benefits of studying international finance
The growing importance of international finance
Topics covered in this book
Summary
Review questions
Assignment problems
Bibliography
Parallel material for case courses
Appendix A
Appendix B

xiii
xviii
1

1

1
2
13
17
17
18
18
19
19
22

PART I

THE MARKETS FOR FOREIGN EXCHANGE
2 AN INTRODUCTION TO EXCHANGE RATES

The foreign bank note market
The spot foreign exchange market
Organization of the interbank spot market
Direct versus indirect exchange and cross exchange rates
Summary
Review questions
Assignment problems
Bibliography
3 FORWARD EXCHANGE

What is forward foreign exchange?
Forward exchange premiums and discounts
Forward rates versus expected future spot rates
Payoff profiles on forward exchange

Outright forward exchange and swaps

27
29

29
32
32
43
50
51
51
52
53

53
54
56
56
58

vii &


CONTENTS
The flexibility of forward exchange
Forward quotations
Summary
Review questions
Assignment problems

Bibliography
4 CURRENCY FUTURES AND OPTIONS MARKETS

Currency futures
Currency options
Forwards, futures, and options compared: a summary
Summary
Review questions
Assignment problems
Bibliography
Appendix A

60
61
65
66
66
67
68

68
75
85
86
87
88
89
89

PART II

THE DETERMINATION OF EXCHANGE RATES
5 THE BALANCE OF PAYMENTS

Influences on currency supply and demand
Principles of balance-of-payments accounting
Balance-of-payments entries and the factors that influence them
Implications of the balance-of-payments accounting identity
The net international investment position
Objectives of economic policy
Summary
Review questions
Assignment problems
Bibliography
6 SUPPLY-AND-DEMAND VIEW OF EXCHANGE RATES

Imports, exports, and exchange rates
The factors affecting exchange rates
The stability of exchange rates
Short-run versus long-run trade elasticities and the J curve
Summary
Review questions
Assignment problems
Bibliography
Appendix A

95
97

97

98
99
108
111
113
114
116
116
117
119

120
122
130
133
135
136
136
137
137

PART III

THE FUNDAMENTAL INTERNATIONAL PARITY CONDITIONS

141

7 THE PURCHASING-POWER-PARITY PRINCIPLE

143

The law of one price
Absolute (or static) form of the PPP condition
The relative (or dynamic) form of PPP

143
144
145

& viii


CONTENTS
Efficient markets (or speculative) form of PPP
The empirical evidence on PPP
Reasons for departures from PPP
Statistical problems of evaluating PPP
The practical importance of PPP
Summary
Review questions
Assignment problems
Bibliography
8 INTEREST PARITY

The investment and borrowing criteria
The covered interest-parity condition
Combining PPP and interest parity
Why covered interest differences persist
Summary
Review questions

Assignment problems
Bibliography

147
148
151
152
154
155
156
156
157
159

160
166
169
171
184
185
186
187

PART IV

MANAGING FOREIGN EXCHANGE RISK AND EXPOSURE
9 FOREIGN EXCHANGE EXPOSURE AND RISK

The importance of understanding risk and exposure and measuring them
The nature of exchange-rate risk and exposure

Examples of foreign exchange exposure
Exposure as a regression slope
Definition of foreign exchange risk
Exposure, risk, and the parity relationships
Summary
Review questions
Assignment problems
Bibliography
10

11

189
191

191
192
193
198
204
205
211
213
213
214

ACCOUNTING EXPOSURE VERSUS REAL EXPOSURE

216

Accounting principles
Real changes in exchange rates
Summary
Review questions
Assignment problems
Bibliography

216
220
226
227
227
228

OPERATING EXPOSURE

230

Operations affected by exchange rates
The exporter
The importer
Summary of effects of exchange rates on exporters and importers
Effect of currency of invoicing and forward hedging
Measuring exposure: an alternative approach
Summary

230
231
240
244

244
249
251

ix &


CONTENTS
Review questions
Assignment problems
Bibliography
12

13

252
253
254

HEDGING RISK AND EXPOSURE

256

Whether to hedge: managerial hedging versus shareholder hedging
Hedging of receivables and payables
The cost of forward hedging
The benefit of forward hedging
Financial engineering: payoff profiles of different hedging techniques
Having a company hedging policy
Summary

Review questions
Assignment problems
Bibliography

256
259
260
264
272
276
276
277
278
279

EXCHANGE-RATE FORECASTING AND SPECULATION

280

Speculation
Market efficiency
Exchange-rate forecasting
Summary
Review questions
Assignment problems
Bibliography

280
283
288

300
302
302
303

PART V

INTERNATIONAL INVESTMENT AND FINANCING
14

15

16

305

CASH MANAGEMENT

307

The objectives of cash management
Investment and borrowing choices with transaction costs
International dimensions of cash management
Summary
Review questions
Assignment problems
Bibliography

307
308

310
319
320
320
321

PORTFOLIO INVESTMENT

322

The benefits of international portfolio investment
International capital asset pricing
Bonds and international portfolio diversification
Settlements of international portfolio investments
Summary
Review questions
Assignment problems
Bibliography

322
331
339
341
341
343
343
344

CAPITAL BUDGETING FOR FOREIGN INVESTMENTS

346

Selecting projects
Difficulties in evaluating foreign projects

346
348

&x


CONTENTS
Cash flows: home versus foreign perspectives
Discount rates: corporate versus shareholder perspectives
The adjusted-present-value technique
Selecting the appropriate discount rates
An example
Actual practice of capital budgeting
Summary
Review questions
Assignment problems
Bibliography
Appendix A
The different forms of taxes
Organizational structures for reducing taxes
Appendix B
17

18

349
351
351
354
356
360
361
362
362
363
364
364
367
369

THE GROWTH AND CONCERNS ABOUT MULTINATIONALS

373

The growth of MNCs
Special issues facing MNCs: transfer pricing
Special issues facing MNCs: country risk
Problems and benefits from the growth of MNCs
Transnational alliances
Summary
Review questions
Assignment problems
Bibliography

373

381
384
390
393
393
395
395
396

INTERNATIONAL DIMENSIONS OF LONG-TERM FINANCING

397

Equity financing
Bond financing
Bank financing, direct loans, and the like
Government and development-bank lending
Other factors affecting the financing of subsidiaries
Financial structure
Summary
Review questions
Assignment problems
Bibliography

397
402
410
413
413
414

417
418
418
419

PART VI

INSTITUTIONAL STRUCTURE OF INTERNATIONAL TRADE AND FINANCE
19

20

421

MULTINATIONAL BANKING

423

The Eurodollar and offshore currency markets
Multinational banking
Summary
Review questions
Assignment problems
Bibliography

423
431
441
442
442

443

INSTRUMENTS AND INSTITUTIONS OF INTERNATIONAL TRADE

445

Extra dimensions of international trade
International trade involving letters of credit: an overview of a typical transaction

445
445

xi &


CONTENTS
Alternative payment and guaranteeing procedures
The financing of international trade
Countertrade
The institutions regulating international trade
Summary
Review questions
Assignment problems
Bibliography

450
452
456
459
463

464
464
465

PART VII

THE INTERNATIONAL MACROECONOMIC ENVIRONMENT: THEORIES
AND PRACTICES
21

22

23

467

ASSET-BASED THEORIES OF EXCHANGE RATES

469

Stock versus flow theories of exchange rates
The monetary theory of exchange rates
The asset approach to exchange rates
The portfolio-balance approach to exchange rates
Theories of exchange-rate volatility
Summary
Review questions
Assignment problems
Bibliography

469
469
474
475
479
483
484
484
485

ALTERNATIVE SYSTEMS OF EXCHANGE RATES

487

The classical gold-standard system
The Bretton Woods and dollar standards
The European monetary system (EMS)
Hybrid systems of exchange rates
Target zones
Summary
Review questions
Assignment problems
Bibliography
Appendix A
Appendix B

488
491
496
499

502
504
506
506
507
508
511

THE INTERNATIONAL FINANCIAL SYSTEM: PAST, PRESENT, AND FUTURE

514

The past
The present
The future
Degree of exchange-rate flexibility: fixed versus flexible exchange rates
Summary
Review questions
Assignment problems
Bibliography

514
529
529
536
543
544
545
546

Glossary
Name index
Subject index

& xii

547
573
578


Illustrations

FIGURES
1.1
1.2
1B.1
1B.2
2.1
2.2
2.3
2.4
2.5
3.1
3.2
4.1
4.2
4.3
4.4
4.5

4A.1

Percentage of GDP arising from exports
International investment position of the United States
The gain from the better allocation of capital
Utility from different consumption patterns
Daily turnover in the US foreign exchange market, 1986–2001
Organization of the foreign exchange market
Interbank spot and selected forward exchange rates
Direct versus indirect exchange: zero transaction costs
Direct versus indirect exchange: nonzero transaction costs
Payoff profile on forward contract to buy ¤1 million
Payoff profile on forward contract to sell ¤1 million
Prices of principal CME currency futures: September 18, 2003
Payoff profile for purchase of euro futures contract
Premiums on principal CME options on currency futures: September 18, 2003
Payoff profiles of buyer and writer of euro call option for ¤125,000
Payoff profiles of buyer and writer of euro put option for ¤125,000
Equivalence of buying foreign currency European call and selling put, versus buying the
foreign currency forward
4A.2 Equivalence of selling foreign currency European call and buying put, versus selling the
foreign currency forward
6.1 Deriving the supply of pounds
6.2 Deriving the demand for pounds
6.3 The exchange rate from imports and exports
6.4 Deriving the demand for imports
6.5 Deriving the export supply curve
6.6 Inflation in relation to supply and demand
6.7 Inflation and exchange rates
6.8 Currency supply and import elasticity

6.9 Stability of foriegn exchange markets
6.10 The J curve
7.1 US–Mexican inflation and the peso–dollar exchange rate
8.1 Dollar versus hedged pound investments
8.2 Dollar versus hedged pound borrowing
8.3 Covered interest arbitrage: dollar borrowing and pound investing

3
10
23
24
33
35
41
44
47
58
59
69
74
76
84
85
90
90
121
122
123
124
125

126
127
131
132
134
154
161
164
165

xiii &


ILLUSTRATIONS
8.4
8.5
8.6
8.7
8.8
9.1
11.1
11.2
11.3
11.4
11.5
11.6
11.7
11.8
11.9
11.10

12.1
12.2
14.1
14.2
15.1
15.2
15.3
15.4
15.5
15.6
15.7
15.8
15.9
17.1
18.1
19.1
19.2
20.1
20.2
20.3
20.4
20.5
21.1
21.2
21.3
22.1
22.2
22.3
22.4
23.1

& xiv

The covered interest parity diagram
The interdependence of exchange rates, interest rates, and inflation rates
One way and round-trip interest arbitrage
Interest parity in the presence of transaction costs, political risk, or liquidity premiums
A more roundabout one-way arbitrage
Exposure as the slope of a regression line
Exporter and devaluation in a competitive market
Exporter and devaluation in a competitive market: effect of cost increases
Devaluation and the demand curve
Exporter and devaluation in an imperfectly competitive market
Exporter and devaluation in an imperfectly competitive market: foreign-currency units
The importer and a devaluation
Importer and devaluation in foreign-currency units
Importer of inputs and devaluation
Exporter with payables exposure: dollar accounting
The J curve
Payoff profiles, payables exposure, and resulting exposure with forward and futures
contracts
Payoff profiles from option hedges
Example of Navistar International’s foreign exchange netting system
Digital Equipment’s weekly cash cycle
Correlations between US and other countries’ stock markets, US dollars, 1980–90
Correlations between Japanese and other countries’ stock markets, Japanese yen,
1980–90
Correlations between British and other countries’ stock markets, British pounds,
1980–90
The size of the gain from international diversification

Local-market versus exchange-rate components of volatility of US dollar values of
non-US stocks, 1970s and 1980s
The advantages of international diversification with and without exchange risk
The relationship between expected return and total risk
Efficiency frontier of global stocks, US dollar, 1980–90
Contribution of bonds to the globally efficient frontier, US dollars, 1980–90
Euromoney’s country-risk rating scheme
Parallel loans and credit swaps
Deposit and asset shares of foreign banks in the United States, 1990–2001
Share of loans by foreign banks in the United States, 1990–2001
Application and agreement for documentary letter of credit
The draft and banker’s acceptance
The steps in international trade
The steps involved in forfaiting
The different forms of countertrade
The portfolio-balance theory: effect of open-market operations
Real income growth and the portfolio-balance theory
Exchange-rate overshooting
The workings of the gold-exchange and dollar standards
The price-level adjustment mechanism of the gold-exchange and dollar standards
Crawling peg
Target zones for exchange rates
Post-war changes in economic importance

167
171
174
175
178
199

232
235
236
237
239
241
243
244
246
246
273
275
316
318
323
324
324
327
328
330
333
334
341
386
412
432
432
447
448
449

454
458
476
478
480
493
495
500
503
530


ILLUSTRATIONS
23.2
23.3
23.4

US and Japanese trade balances, 1965–2002
US bilateral trade balance with China and Japan, 1985–2003
Stabilizing and destabilizing currency speculation

533
534
540

TABLES
1.1
1.2
1.3
1.4

1A.1
1A.2
2.1
2.2
3.1
3.2
3.3
3.4
3.5
3.6
4.1
4.2
4.3
4.4
4.5
4.6
4A.1
5.1
5.2
7.1
8.1
8.2
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8

10.1
10.2
12.1
12.2
13.1

Aggregate international trade versus GDP
Selected foreign exchange gains, 2001
Selected foreign exchange losses, 2001
The volatility of exchange rates
The situation with no international trade
Input/output under free trade
Exchange rates on foreign bank notes (Traveler’s dollar – October 22, 2002)
Geographical distribution of average daily foreign exchange turnover, April 2001
Foreign exchange net turnover by market segment: daily averages, April 2001
Per annum percentage premium (þ) or discount (À) on forward foreign exchange
vis-a`-vis the US dollar
Unanticipated changes in the spot exchange rate and gains or losses on forward purchase
of ¤1 million at $1.15/¤
Unanticipated changes in the spot exchange rate and gains or losses on forward sale
of ¤1 million at $1.15/¤
Foreign exchange derivative turnover by currency pair: daily turnover in April 2001
Bids and asks on pounds
Settlements on a pound futures contract
Realized spot rates and gains/losses on futures to buy euros
Impact of variables affecting currency call and put option premiums
Payoffs on purchase of euro call option
Payoffs on purchase of euro put option
Forwards, futures, and options compared
European option put-call forward parity

Summary format of the US balance of payments, 3rd quarter, 2002
International investment position of the United States year-end 2001
Average absolute deviations from PPP
Exchange rates and interest rates on different currency-denominated 3-month bank deposits
Points off the interest parity line
Exposure on a contractual asset: euro bank deposit
Exposure on a contractual liability: euro bank loan
Exposure on a noncontractual asset: Euro-zone exporter
Exposure on a noncontractual asset: Euro-zone exporter
Exposure on a noncontractual asset: Euro-zone importer
Exposure on a noncontractual asset: euro bond
Exposure on a noncontractual asset: dollar bond
Exposure on a noncontractual asset: foreign real estate
Earnings on domestic versus foreign financial assets
Earnings on foreign fixed assets
Dollar payments on £1-million accounts payable using different hedging techniques
Payoffs from different hedging techniques
Test of unbiasedness of forward rates as predictors of future spot rates, monthly
data 1978–87

3
6
7
12
20
21
30
32
53
55

57
58
63
64
71
73
79
83
85
86
92
100
112
149
163
168
193
194
195
195
196
197
197
198
222
225
265
272
287

xv &


ILLUSTRATIONS
13.2
13.3
13.4
13.5
13.6
13.7
13.8
14.1
15.1
15.2
15.3
15.4
16.1
16.2
16A.1
17.1
17.2
18.1
18.2
18.3
19.1
19.2

Correlation coefficients between the yen–dollar spot rate and various possible spot-rate
predictors, 1974–87
Correlation coefficients between the Deutschemark–dollar spot rate and various possible

spot-rate predictors, 1974–87
The performance of econometric-oriented services
Speculative return on capital from following the advice of econometric services
Speculative return on capital from following the advice of technical services
Connection between past changes in exchange rates and median forecasts of future rates:
different forecast horizons
Forecasting methods of Euromoney respondents
Factors affecting working-capital management
Monthly US dollar returns and risks for national stock markets, 1994–2002
Correlations between US dollar monthly returns in automobile manufacturing, 1986–91
Correlations between US dollar monthly returns in the consumer electronics industry,
1986–91
Composition of US dollar weekly returns on individual foreign stock markets, 1980–85
Value of a £1-million concessionary loan
Adjusted-present-value elements for Turkish jeans factory
Corporate income tax rates, 2003
The 50 largest nonfinancial MNCs, ranked by total assets, 2000
Euromoney’s country-risk ranking, 2003
Costs of foreign-currency bonds
Sources of funds for subsidiaries
Mean and standard deviation of debt to asset ratios, sorted by type of legal system
Change in balance sheets from $100 of primary deposits
Activities open to different institutions in different centers

289
289
293
294
295
299

299
315
325
326
326
329
353
359
365
374
388
405
411
415
430
438

EXHIBITS
1.1
1.2
2.1
2.2
3.1
3.2
4.1
5.1
9.1
9.2
10.1
10.2

11.1
12.1
12.2
13.1
13.2
14.1
15.1
15.2
16.1

& xvi

Currency matters: corporate experiences
Getting a grip on globalization
Institutional basics of the foreign exchange market
An exchange on the exchange: a conversation between market-makers in the foreign
exchange market
Structure of the forward market
Differences between outright forwards and swaps
The scope for writing options
Extraterrestrial trade or the ether? Data difficulties in the balance of payments
Hedging horizons
Flying high: risk and exposure at American airlines
Translating accountants’ and economists’ languages
From historical to current rates: the rationale for a change in approach
A practical solution to estimating operating exposure
To hedge or not to hedge: Merck’s motives
Different corporate choices over hedging
The success of professional forecasters
Good luck or good judgement?

Decentralizing currency management at general electric
Home bias and corporate governance
Evolution of capital market integration
Investment strategies: a dynamic matter

8
9
36
39
61
62
82
107
207
209
218
219
249
258
261
297
298
314
336
340
347


ILLUSTRATIONS
16.2

17.1
17.2
17.3
18.1
18.2
18.3
19.1
19.2
20.1
20.2
22.1
22.2
23.1
23.2
23.3
23.4
23.5

Competitive pressure to pursue FDI
Counting on a good name
Multinationals: creatures of market imperfections
Do US multinationals export jobs?
Overstating differences: US-Japanese borrowing costs more similar than it seems
Going abroad: the appeal of Euroequities
Special drawing rights (SDRs)
Foreign bank operations in the United States
Derivatives: differentiating the hyperbole
Just-in-time inventory systems: too late for The Merchant of Venice
US free-trade zones
The Wonderful Wizard of Oz: a monetary allegory

Alphabet soup: ERM, EMS, ECU, and all that
Seeing the forest through the trees: the Bretton Woods vision
Bretton Woods faces the axe
The cost of change: conversion to the euro
The bank for international settlements
International trade and the environment

348
377
380
392
399
400
409
433
440
453
461
492
498
517
521
528
531
535

xvii &


Preface

This book is intended for use in MBA and senior-level undergraduate business courses in international
finance and international business. It is comprehensive, covering both the markets and management of
multinational business. It is designed to be used in its entirety in courses that cover all areas of international
finance, or to be used selectively in courses dealing only with international financial markets or only with
international financial management. To the extent possible, the two major subdivisions of international
finance are self contained, being delivered in separate segments.
The book is specifically designed for students who have taken introductory economics and finance, and
who wish to build upon the basic financial and economic principles they have acquired. By assuming these
prerequisites, this book is able to go further than competing textbooks in international finance. It is able to
introduce the student to the new and exciting discoveries and developments in the dynamic and rapidly
expanding field of international finance. These discoveries and developments, many of which have occurred
during the last few years, are extensions of the principles of finance and economics.
Of course, it is necessary to recognize that business students, whether concentrating in finance or in
international business, have a practical interest in the subjects they take. Consequently, a good textbook in
international finance must cover real managerial topics such as how to evaluate foreign investment
opportunities, where to borrow and invest, how exchange rates affect cash flows, what can be done to avoid
foreign exchange exposure and risk, and the general financial management problems of doing business in
the global environment. However, even these highly practical topics can be properly dealt with only by
applying basic financial and economic principles that many other international finance textbooks appear
reluctant to employ. As a result, despite adequate levels of preparation, generally including thorough
introductions to economics and finance, the student often receives a rather descriptive treatment of these
topics that fails to build on the foundations of previous courses. For this reason, many MBA students and
undergraduate business majors with solid backgrounds in, for example, the consequences of arbitrage or
the principles of capital budgeting feel they move sideways rather than forward into international finance.
The topics in this text are covered from the perspective of a person who wishes to learn about the
financial management of an internationally oriented business. However, it is important that managers also
understand international financial developments on a macroeconomic level. Such an understanding enables
managers to anticipate economic changes and adjust to what they expect to occur. Because of this double
level of interest in the forces behind events and the consequences of these events for the firm, this book

includes several chapters on the international finance of the economy. However, these chapters are divided
into two parts, with the essential material on the international financial environment limited to only
two chapters in the early part of the book. This is to provide the book with a financial management focus,

& xviii


PREFACE

unlike the previous three editions that have given more priority to the wider picture of the global economy.
The aspects of the international financial environment that are less essential to day-to-day international
financial decisions are in a separate section at the end of the book. Nevertheless, even at this more aggregate
level, a managerial perspective is taken, with the material linked to factors relevant to the handling of
volatility that has its roots in global events.
This book represents a major revision and updating of the third edition of International Finance that go
beyond moving less essential material on the international financial environment to later in the book. New
topics have been included and topics previously covered have been considerably rearranged and reintegrated.
In addition, additional examples have been provided. The guiding principle throughout this substantial
revision has been to bring the book closer to the syllabus that is emerging in one-semester international finance
courses in MBA and senior level undergraduate business programs. Most particularly, an attempt has been
made to go beyond theory and into the vital and increasingly important real world of international finance.
As with previous editions, a substantial revision has been necessary because the international financial
developments that are occurring are nothing short of spectacular. For example, new markets and
instruments are emerging at a frantic pace, in part as a response to exchange rates that at times have been so
volatile they have grabbed the headlines, not of the business section of the newspaper, but of the front page.
The day-to-day lives of people have been affected by events such as the introduction of the euro, a common
currency now shared by numerous countries in Europe. The euro represents an unprecedented experiment
in international financial cooperation with huge implications for the traveler and the person in the street as
well as corporate financial management. Great fortunes have been made and lost in foreign exchange. News
reports have also been full of exchange rate crises in Asia, South and Central America, and Russia, and

economic summits of world leaders dealing with these periodic crises. At the same time, there has been an
explosion of research in international finance and international financial management. The revisions in this
fourth edition of International Finance reflect the important recent developments and current research that
have sharpened the insights from studying this dynamic subject.
This book has evolved over a number of years while teaching or doing research at the University of
British Columbia and also at the Hebrew University, Jerusalem; the University of California, Berkeley; the
Massachusetts Institute of Technology; the London Business School; the University of New South Wales;
and the University of Exeter. I am indebted to all these institutions, especially the Sauder School of Business
at the University of British Columbia, which has been my home base for over three decades.
An author’s debts are a pleasure to acknowledge, and in the course of four editions of this book I have
incurred many I would find difficult to repay. A huge debt is owed to Cynthia Ree who has spent endless
days and weeks providing a usable electronic copy from which I could work, and to my colleague Ali Lazrak
who has provided valuable comments. The help offered by reviewers has been immensely important in
improving the final product. Only the anonymity of the individual reviews prevents me from apportioning
the vast credit due to them. My wife, Kate, son Adam, and daughter Naomi have provided professional and
indispensable help in preparing the manuscript. My son Jonathan also helped by asking questions that
sharpened my understanding of difficult matters. Too numerous to mention individually but of great
importance were the students in my MBA and undergraduate courses in international finance at the
University of British Columbia, whose reactions have been a crucial ingredient in the revision of this text.
It is to my wife, Kate, and my daughter Naomi that I owe my greatest thanks. In addition to playing a vital
role in preparing and checking the manuscript they have provided the moral support and encouragement
that have made a fourth venture far less stressful than I had imagined.
Maurice D. Levi
Vancouver, BC

xix &



Chapter 1

The world of international finance

The globe is not a level playing field.
Anonymous

UNIQUE DIMENSIONS OF
INTERNATIONAL FINANCE

While tradition dictates that we continue to refer to
the subject matter in this book as international
finance, the modifier ‘‘international’’ is becoming
increasingly redundant: today, with fewer and
fewer barriers to international trade and financial
flows, and with communications technology
directly linking every major financial center, all
finance is becoming ‘‘international.’’ Indeed, not
only are domestic financial markets increasingly
internationally integrated, but the problems faced
by companies and individuals in different lands are
remarkably similar.
Even though most if not all finance must be
viewed at the international level, there are special
problems that arise from financial and trading
relations between nations. These are the problems
addressed in this book. Many of these problems are
due to the use of different currencies used in different countries and the consequent need to
exchange them. The rates of exchange between
currencies – the amount of a currency received for
another – have been set by a variety of arrangements, with the rates of exchange as well as the

arrangements themselves subject to change.
Movements in exchange rates between currencies
can have profound effects on sales, costs, profits,
asset and liability values, and individual well-being.

Other special, uniquely international financial
problems arise from the fact that there are political
divisions as well as currency divisions between
countries. In particular, the world is divided into
nation-states that generally, but not always, correspond to the currency divisions: some nations share
currencies, such as the euro that is the common
currency for numerous European nations, and the
Russian ruble that is still used by several former
Soviet states. Political barriers provide additional
opportunities and risks when engaging in overseas
borrowing and investment. International finance has
as its focus the problems managers face from these
currency and country divisions and their associated
opportunities and risks.

THE BENEFITS OF STUDYING
INTERNATIONAL FINANCE

Knowledge of international finance can help a
financial manager decide how international events
will affect a firm and what steps can be taken to
exploit positive developments and insulate the firm
from harmful ones. Among the events that affect the
firm and that must be managed are changes in
exchange rates as well as interest rates, inflation

rates, and asset values. These different changes
are themselves related. For example, declining
exchange rates tend to be associated with relatively

1&


THE WORLD OF INTERNATIONAL FINANCE

high interest rates and inflation. Furthermore, some
asset prices are positively affected by a declining
currency, such as stock prices of export-oriented
companies that are more profitable after devaluation. Other asset prices are negatively affected, such
as stock prices of companies with foreign-currency
denominated debt that lose when the company’s
home currency declines: the company’s debt is
increased in terms of domestic currency. These
connections between exchange rates, asset and liability values, and so on mean that foreign exchange
is not simply a risk that is added to other business
risks. Instead, the amount of risk depends crucially
on the way exchange rates and other financial prices
are connected. For example, effects on investors
when exchange rates change depend on whether
asset values measured in foreign currency move in
the same direction as the exchange rate, thereby
reinforcing each other, or in opposite directions,
thereby offsetting each other. Only by studying
international finance can a manager understand
matters such as these. International finance is not
just finance with an extra cause of uncertainty. It is a

legitimate subject of its own, with its own risks and
ways of managing them.
There are other reasons to study international
finance beyond learning about how exchange rates
affect asset prices, profits, and other types of effects
described earlier. Because of the integration of
financial markets, events in distant lands, whether
they involve changes in the prices of oil and gold,
election results, the outbreak of war, or the
establishment of peace, have effects that instantly
reverberate around the Earth. The consequences of
events in the stock markets and interest rates of one
country immediately show up around the globe,
which has become an increasingly integrated and
interdependent financial environment. The links
between money and capital markets have become so
close as to make it futile to concentrate on any
individual part.
In this book we are concerned with the problems faced by any firm whose performance is affected by the international environment. Our analysis
is relevant to more than the giant multinational

&2

corporations (MNCs) that have received so much
attention in the media. It is just as valid for a
company with a domestic focus that happens to
export a little of its output or to buy inputs from
abroad. Indeed, even companies that operate only
domestically but compete with firms producing
abroad and selling in their local market are affected

by international developments. For example, US
clothing or appliance manufacturers with no overseas sales will find US sales and profit margins
affected by exchange rates which influence the
dollar prices of imported clothing and appliances. Similarly, bond investors holding their own
government’s bonds, denominated in their own
currency, and spending all their money at home, are
affected by changes in exchange rates if exchange
rates prompt changes in interest rates. Specifically,
if governments increase interest rates to defend
their currencies when their currencies fall in value
on the foreign exchange markets, holders of
domestic bonds will find their assets falling in value
along with their currencies: bond prices fall when
interest rates increase. It is difficult to think of any
firm or individual that is not affected in some way or
other by the international financial environment.
Jobs, bond and stock prices, food prices, government revenues, and other important financial variables are all tied to exchange rates and other
developments in the increasingly global financial
environment.
THE GROWING IMPORTANCE OF
INTERNATIONAL FINANCE

While we shall emphasize the managerial issues of
international finance in this book, it is important to
emphasize that the international flows of goods and
capital that are the source of supply of and demand
for currencies, and hence essential to the subject
of international finance, are fundamental to our
well-being. A strong currency, for example, ceteris
paribus, improves a country’s standard of living:

the currency buys more in world markets. Not
only does a strong currency allow citizens to buy
more imports, they can also buy more domestically


THE WORLD OF INTERNATIONAL FINANCE

produced products that are internationally traded
because a country’s citizens have to compete with
foreigners for their own country’s tradable products. The gain in standard of living from a rising
currency is also evident when living standards are
compared between nations. International rankings
of living standards require conversions of localcurrency incomes into a common measure, usually
the US dollar. A rising currency moves a country up
the ladder by making local incomes worth more
dollars.
Citizens also gain from the efficient global allocation of capital: when capital is allocated to its best
uses on a global scale, overall returns are higher and
these extra returns can be shared among the global
investors. Let us therefore pause to consider the
evidence of the international movement of goods
and capital. We shall also take a look at the sources
of gains from the flows of goods and capital. We
shall see that international finance is a subject of
immense and growing importance.
The growth of international trade

International trade has a pervasive importance for our
standard of living and our daily lives. In the department store we find cameras and electrical equipment
from Japan and clothing from China and India. On the

street we find automobiles from Germany, Japan,
Korea, Sweden, and France using gasoline from
Nigeria, Saudi Arabia, Great Britain, Mexico, and
Kuwait. At home we drink tea from India, coffee
from Brazil, whiskey from Scotland, beer from
Germany, and wine from just about every country on
Earth. We have become so used to enjoying these
products from distant lands that it is easy to forget
they are the result of complex international trading
and financial linkages discussed in this book.

commerce. For example, since 1950, world trade
has grown by about 6 percent per annum, roughly
twice that of world output over the same period.
During the nineteenth century, international trade
grew at such a tremendous rate that it increased by
a factor of 25 times in the century leading up to
the First World War. Even in the period since
1980, a mere moment in the long history of
international trade, the value of trade between
nations has tripled (see Table 1.1). Growth in
the importance of trade in the form of the fraction
of Gross Domestic Product (GDP) consisting of
exports is shown for several countries in Figure 1.1.

& Table 1.1 Aggregate international trade
versus GDP
Year

World exports,

billion US$

Exports/GDP%

1999
1995
1990
1985
1980

4945.9
4531.7
3070.0
1610.8
1541.3

16.0
15.7
14.2
13.7
14.7

Source: National Account Statistics: Analysis of Main
Aggregates, United Nations, New York, 2003.
50%
1970
1990
1999

40%

30%
20%
10%
0%
Canada

South
Korea

United
Kingdom

United
States

India

& Figure 1.1 Percentage of GDP arising from
exports

Record on the growth of trade

Peoples and nations have been trading from time
immemorial. During the period since records have
been kept the amount of this trade between nations
has typically grown at a faster rate than has domestic

Note
Today, foreign markets represent a more important proportion
of aggregate demand for the products of most countries than in

the past. For example, the fraction of US GDP that is exported
has almost doubled since 1970, while the fraction of South
Korea’s GDP that is exported has almost tripled.
Source: National Account Statistics: Analysis of Main
Aggregates, United Nations, New York, 2003.

3&


THE WORLD OF INTERNATIONAL FINANCE

Indeed, if anything, the published export figures
understate the growth of world trade. This is
suggested by the fact that when the world’s
combined reported exports are compared to
reported imports, global imports exceed exports.
In the absence of extraterrestrial trade, this suggests a reporting error: when properly calculated,
global imports must equal global exports. The
mechanisms for reporting imports are generally
better than those for reporting exports – governments keep track of imports for collection of
duties and for safety and health reasons – and
therefore it is likely that exports are understated
rather than that imports are overstated. It is worth
pausing to consider why international trade and the
international financial activity associated with that
trade have grown so rapidly in recent decades.
Reasons for the growing importance of
international trade

There are two principal reasons why international

trade has grown so rapidly:
1

2

A liberalization of trade and investment via
reductions in tariffs, quotas, currency controls,
and other impediments to the international
flow of goods and capital.
An unprecedented shrinkage of ‘‘economic
space’’ via rapid improvements in communication and transportation technologies, and
consequent reductions in costs.

Much of the trade liberalization has come from the
development of free-trade areas such as that of the
European Union (EU) now consisting of more
than two dozen countries from Sweden to Malta and
Portugal to Greece, and that of the United States,
Canada, and Mexico which signed the North
American Free Trade Agreement (NAFTA) in
1993. Similarly, rapid growth of trade has occurred
among the members of the Association of South
East Asian Nations (ASEAN). Indeed, more and
more of global trade is occurring within trading
blocks. This regionalization of trade has important

&4

currency implications, making the trend of paramount importance to international finance. For
example, the euro has become the common currency of many of the members of the EU, motivated

by the desire to reduce the foreign exchange risks
and currency conversion costs of doing business
within this important customs union.1 The previous currencies of this area have completely disappeared: no more German marks, Italian lira, and
so on. The role of the US dollar within NAFTA has
become a source of serious debate: should there be a
North American common currency to reduce risks
and costs in this important and possibly expanding
region?
The second factor contributing to growing trade,
namely the shrinkage of ‘‘economic space’’ caused
by a lower cost of communication and transportation, has had a profound effect. For example, in real
terms, long-distance telephone costs have been
reduced by more than 90 percent since the 1920s.
Connection times have been reduced even more
dramatically: long-distance calls used to be connected manually by operators who would route
calls through available lines.2 The cost of international business travel by air has dropped so
substantially that it can cost little more for a US
executive to meet with an Asian or European client
than another US executive in another US city. Air
freight and ocean tanker costs for transporting
goods have also fallen rapidly. This has resulted in a
globalization of markets and consequent rapid
1 A customs union is different from a free-trade area.
A customs union maintains common levels of tariffs and
other trade restrictions against nonmembers while having
free trade between the union members. A free-trade area
allows countries to maintain different tariffs and other
restrictions against nonmembers. This limits the ability
of goods and services to move freely between members of a
free-trade area: countries must check when products move

across borders to see if they are produced by member
countries or by nonmember countries.
2 See Ronald Abler, ‘‘Effect of Space-Adjusting Technologies
on the Human Geography of the Future,’’ in Human
Geography in a Shrinking World, Ronald Abler, Donald
Janelle, Allen Philbrick and John Sommer (eds), Duxbury
Press, North Scituate, MA, 1975, pp. 35–56.